I read Rob Carrick’s column on small-cap investing in the Globe & Mail over the weekend and thought I would share it with you (see Small Caps: Four Rules to Follow, October 26th, 2007). This blog isn’t intended to focus on traditional equity investing approaches. However, with so many of the alternative energy companies that I’ll look at falling into this category (that is, companies with market caps under $1 billion), the risks and issues of small cap investing are worth talking about from time to time.
The attraction of small caps is the high rate of return that can be had relative to larger more established companies. Carrick makes the comparison, noting that over the past seven year the S&P/TSX Small-Cap Index is up 63% versus 49% for the S&P/TSX Composite Index. However, smaller companies also offer much greater risks for the unwary – and often times even the wary.
To help investor mange these risks, Carrick offers the following four rules (I'm paraphrasing here):
1. Take a hard look at management. For example, do the senior managers own a significant share of the company?
2. If the company’s product or story don’t make sense don't buy it.
3. Let the market do some of your research for you (i.e. look at the 52 week high and low list).
4. Avoid commodity plays.
(That last one is a bit tough when your focus is on energy stocks, even sustainable ones.)
After reading this I took a look around to see what other advice is out there and came up with two columns that seem like they're worth a quick look.
Ken Little writing at About.com:stocks (see Small Cap Stocks Can Pop) does a good job of summarizing the risks associated with small cap stocks and then offers his own four rules:
1. Invest in what you know.
2. Avoid “bleeding edge” technologies.
3. Be realistic.
4. Be patient.
Similarly, Investopedia.com offers an Introduction to Small Caps that examines the pros and cons of investing in this category. The cons are greater risk and the time to properly research prospective stocks.
The reality for the alternative energy sector in the coming years is that a large number of the most interesting companies will fall into the small cap category and may thus be too risky for many investors to own directly. However, if you still think you want to go for the ride, these articles (and many, many other publications) may help you make it a bit less bumpy.